Our research investigates stock splits: why they happen, how they affect shareholder wealth. anf whether they enhance liquidity for splitting firms. Prior research has not reached a clear-cut answer as to the role of stock splits. While there is definitely a favorable stock price reaction to the announcement of splits, the reason for the positive announcement return is.not well-determined. Conventional wisdom suggests that the benefit Of splits comes from improved sham liquidity, yet empirical evidence has produced ambiguous results on liquidity. More detailed theoretical arguments pose stock splits as part of a strategy used by management to signal value, yet such arguments seem overly complex for such a basic management decision. Moreover, in spite of complex explanations. an anomaly remains: splitting firms also experience positive returns on the split execution day. This event is known well in advance. so any associated favorable information should already be priced into the stock. We attack the issue of stock splits from several angles in an attempt to reduce the ambiguity of the prior studies. We center our analysis on NASDAQ firms because such firms are more likely to desire liquidity enhancement than the cohort of larger firms that trade via the exchanges. We find that stock splits cause at least two things to happen. First, the dollar spread falls. Second, the average size of trades falls. We attempt to link these liquidity factors to other characteristics of stock splits. As in the prior studies, we find that splitting firms experience positive stock price appreciation at the time of the split announcement. In addition, the split comes at the end of an extended run-up in equity value (over the preceding five years as well as the preceding two weeks) and appears to represent market verification of improvements in cash flows. Like the earlier work, we also find positive price movements on the date of the execution of stock splits. But this latter price movement is actually rather different from the announcement day stock returns. Them is little or no run-up in prices in the weeks and days prior to split execution, as the positive return occurs quite discretely on the ex-day. Consistent with this discreteness, the observed price behavior does not appear to reflect actual changes in equity value, but instead is related to order imbalances consequent to the execution. We link these order imbalances to an inflow of new shareholders following split execution. Conventional wisdom is supported by the data- We find that firms use stock splits as a mechanism to expand the shareholder base. The incoming orders that accomplish this function are necessarily one-sided, that is, buyers must outnumber sellers. New stockholders enter on the ask side of the spread and cause a temporary, asymmetric increase in the bid-ask spread of splitting firms. This movement in the spread shows up in stock prices as a positive return; yet these returns are illusory because an investor could not set up a trading rule that profited from a roundtrip transaction of buying at the ask and selling at the bid surrounding the execution of the split. The new shareholders are predominately institutions. The number and fraction of institutional investors increases following stock splits. Indeed, the increase in institutional owners is directly related to the order imbalances around the ex-day and the illusory ex-day abnormal return. The increase in institutional investors tells us something about who is valuing the liquidity created by the splits. Since institutions can be assumed not to face the wealth constraints possibly borne by individual investors, it seems that splits are not used to improve liquidity for prospective shareholders. Instead, splits enable existing shareholders to sell off, in round lots, a portion of their ownership in the splitting firms. Individual shareholders desire to sell a portion of their holdings for diversification reasons related to the significant run-up experienced by their firms prior to the splits. Stock splits enable diversification through a partial. rather than a complete, sell-off of shares. The results indicate that stock splits are a useful management tool. For firms that have had the good fortune to rise in value, a split can aid small shareholders by giving them a low-cost means to sell off some, but not all, of their holdings. While the split itself does not increase the size of the corporate pie, it does give old shareholders the flexibility to share their portion with new investors.
